Tax Limitations on Business Losses

Tax Limitations on Business Losses

Just because your business has suffered financial losses doesn’t mean you can write them all off. Certain rules in the tax law apply to business losses to limit deductions for the losses. This post provides a straight forward base knowledge and tips on a very specific issue; the tax limitation on business losses, i.e.; (1) Understanding The Tax Basis, How to adjust your tax basis on a partnerships, LLCs, and S Corporations, (2) Understanding The Hobby Losses Rule, its impact, How To Prove Profit Motive, Can you use presumption of profit motive? (3) Understanding The Passive Activity Loss Rules, its limitation (exception), its impact, (4) Understanding the At-Risk Rules and its impact. They come with clear and yet easy to understand illustrations.

Knowing that an economic downturn recently is part of the natural economic cycle and that eventually conditions will improve may be little comfort now. However, you can weather this economic storm by using sound strategies to see you through. Some businesses, though, may be on the ropes or may even be forced to go under.

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Tax and legal rules maybe your friends or your enemies especially when your business is on loss position. Understanding the rules and its limitations at least can help you get out from under your business burden.

Understanding The Tax Basis

If you are an owner of partnership, limited liability company (LLC), or S corporation (a pass-through entity), business losses claimed on your personal return cannot exceed your tax basis in the company. Losses in excess of basis can be carried forward and used in future years to the extent of basis at that time. There is no time limit on these carry forwards.

How To Adjust Your Tax Basis On Partnerships And LLCs

Basis is determined, in part, by the way in which an owner acquires his or her interest in the company:

If the interest is acquired by contributing directly to the entity (typically in the start-up of the company), basis is the cash and an owner’s basis of the property contributed to the company

If the interest is purchased from a previous owner, basis is the cash and the value of the property paid. If the interest is acquired by performing services for the company, basis is the amount of compensation reported.

However, an interest only in the profits of the company, and not a capital interest, is not taxable under certain conditions and, thus, does not give rise to any basis. If the interest is inherited from a deceased owner, basis is the value of the interest for estate tax purposes (generally its value on the date of death).

Once you know your starting basis, adjust it annually—up or down—by the following items.

Increase basis by:

The owner’s distributive share of the company’s income.

The owner’s share of tax-exempt income, such as life insurance proceeds.

Excess of depletion deductions over the basis of depletable property.

Additional capital contributions.

Share of new partnership liabilities (limited partners in limited partnerships do not increase their basis by a share of liabilities assumed by the general partners).

Decrease basis by:

The owner’s distributive share of company losses (including capital losses).

The owner’s share of expenses those are not deductible in figuring the company’s income.

Distributions to the owner by the company.

The owner’s share in any decrease in partnership liabilities.

How To Adjust Your Tax Basis On S Corporations

Basis for purposes of deducting pass-through losses means your basis in your S corporation stock (essentially what you contributed to the corporation to acquire your shares), plus any money you lent to the corporation. If you acquired the shares by inheritance, the basis generally is the share’s value on the date of death, reduced by the portion of the value attributable to income in respect of a decedent (earnings accrued before death but paid out after death).

Notes: Guaranteeing a third party’s loan to the corporation does not, in and of itself, increase your basis. Only when the corporation defaults and you are required to make good on your guarantee can you add the payments to your basis. You cannot increase your basis by your share of corporate liabilities.

Once you know your starting basis, adjust it annually—up or down—by the following items.

Increase basis by:

The owner’s share of the corporation’s ordinary income.

The owner’s share of separately stated items reported on other than tax-exempt income.

Excess of depletion deductions over the basis of depletable property.

Additional capital contributions.

Decrease basis by:

The owner’s share of the corporation’s losses.

The owner’s share of expenses that are not deductible in figuring the company’s income.

Non-capital and nondeductible corporate expenses reported on other than tax-exempt income, such as 50 percent of meals and entertainment costs and nondeductible penalties.

Distributions not includible in the shareholder’s income, such as dividends in excess of basis.

Understanding The Hobby Losses Rule

If your business has losses this year, that may not be a unique situation and the losses are probably deductible according to the rules discussed in this section. But if you suffer losses year after year, you may not be permitted to deduct losses in excess of business income unless you can show that you have undertaken the business in order to make a profit. This limitation on losses is called the “hobby loss rule”. It is designed to prevent people who collect coins and stamps, breed dogs and cats for fun, or engage in other hobby activities from deducting what the law views as personal expenses. Any activity done mainly for recreation, sport, or other personal enjoyment is suspect, but the hobby loss rule can apply to any activity.

Impact Of Hobby Classification

If you can’t prove that you have a profit motive, then any year in which you make money must be fully reported, but any year you have losses (expenses in excess of revenue), you cannot deduct them. These losses are lost forever (you can’t carry them forward).

How To Prove Profit Motive

There is no bright line that you can rely on to show you have a profit motive; it’s a matter of the facts and circumstances of your situation. Some factors that help demonstrate a profit motive:

You carry on the activity in a businesslike manner (e.g., you keep good books and records, have a separate business bank account, and have a written business plan).

You spend considerable time and effort on the activity.

You depend on the activity for income.

You change your methods of operation from those that don’t work to those that do.

You have been profitable in some years.

You turn to advisers to help make you profitable.

You expect to make a profit from the appreciation of assets in the business.

Presumption Of Profit Motive

You can delay an official tax examination [by government] of your business if you choose to rely on a presumption: If you are profitable in three out of five years (two out of seven years for horse-related activities) from the time you start up, you’re presumed to be engaged in the activity for profit [You use the presumption by filing the Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit, within three years of the due date of the return for the year in which you first carry on the activity]. But opting to use this presumption virtually guarantees that the tax office will look closely at your business, so most tax experts don’t advise using the presumption.

Understanding The Passive Activity Losses

Owners of rental real estate may be hit hard in certain economic situations; units may be vacant for some time while the cost of operations keeps rising. So, too are many other investors in businesses that have been floundering under tight credit and escalating prices. These owners need to pay special attention to the passive activity losses.

Example: You are a silent partner in a business that is struggling. Your share of the loss for this year is $10,000 (assume you have no other passive activities). You can not deduct the loss this year, because you do not have any passive activity income to offset it. You can carry the loss forward, though. Say the business goes under next year. You can deduct the $10,000, plus any loss for next year, on next year’s return.

Similar rules apply to tax credits related to passive activities. For instance: an owner of a certified historic building may be eligible for a credit for rehabilitation of the structure, but the credit would be limited by the passive activity losses rules.

Exceptions To The Passive Activity Losses Rules

You can deduct losses beyond the passive activity losses limits in two key situations:

[1]. If you own rental real estate and you actively participate in the activity [e.g.: you set rents, screen tenants, and review expenses], you can deduct excess losses up to $25,000 each year if your “adjusted gross income” does not exceed $100,000. The $25,000 limit is reduced as “adjusted gross income” rises to $150,000; no excess loss is allowed once the adjusted gross income tops $150,000. These dollar amounts are halved for married persons filing separate returns.

Example: You own a multifamily rental property. Rental income for the year is $40,000; rental expenses for the year (including depreciation on the building) are $70,000. Even though you use a management agent to collect the rents, you actively participate in the activity by setting the rents and screening tenants. Your adjusted gross income for the year is $95,000. Of your $30,000 loss ($70,000 ? $40,000), you can deduct $25,000 this year; the $5,000 excess loss is a suspended loss that is carried forward.

[2]. You are a real estate professional who can deduct all of your losses. To qualify as a real estate professional, you must work in construction, conversion, management, brokerage activities, or rental real estate, and you must devote a certain amount of time (fixed by law) to the real estate activities.

Passive activity loss rules to see how the rules apply to them and whether and to what extent they can take losses to ease their financial burden. If you work full-time in the day-to-day activities of your business, then the passive activity loss rules probably don’t apply to you. But if you do not materially participate in a business activity you own, or that activity is rental real estate [regardless of material participation], the passive activity loss rules may limit the amount of losses you can deduct each year.

Impact Of The Passive Activity Loss Rules

Losses [deductions in excess of income] from “passive activities [business you don’t materially participate in and rental real estate activities]” cannot be deducted in excess of passive activity income for the year. Excess passive losses can be carried forward and used in future years to the extent of passive activity income in those years [called “suspended losses“].

You can claim all suspended losses in the year you dispose of your entire interest in the activity. A disposition means a sale to an unrelated party, abandonment of the business, or a business becoming completely worthless.

Understanding The At-Risk Rules

In the heady days of tax shelters, it was not uncommon for someone to invest in a business by contributing only a small sum of cash and a large note on which there was no personal liability [but which was used to create basis against which to claim losses]. These investments threw off losses that investors took to offset their income from other sources. The risk to the investor was small; if the business failed, only the small cash investment was lost. Congress closed this loophole by creating the at-risk rules.

The at-risk rules prevent you from deducting losses in excess of amounts that you have at stake in a venture. At-risk amounts include cash contributions, the basis of property you contribute, and notes for which you are personally liable (your economic stake in the venture).

Impact Of The At-Risk Rules

If you are subject to the at-risk rules, losses in excess of your at-risk basis [cash, the basis of property you contributed, and notes for which you are personally liable] cannot be deducted currently. They can be carried forward and used in a future year if your at-risk basis increases. There is no cap on the carry forward period.

When the activity is sold, gain is treated as income from the activity, so you can then offset the gain by the amount of your carried-forward losses. The at-risk rules are figured on Form “At-Risk Limitations“. The at-risk rules are applied before the passive activity loss rules are applied.

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